And right now LIBOR tells us that this financial mess still has room to run.

As indicators go, recent developments have demonstrated that the LIBOR system is arguably corrupt. Until now, LIBOR always has been constructed by industry insiders – with little in the way of oversight or regulation. It drives billions of dollars of trades and transactions a day. And it's publicly available at 11:30 a.m. (London time) each business day.

Now regulatory authorities are investigating the entire LIBOR process, and that makes it as close to insider information as we're going to get.

LIBOR is calculated entirely using data provided by insiders from 16 banks and reflects the daily borrowing rate in U.S. dollars, European euros and Japanese yen that banks extend to their best customers – each other.

Theoretically, it's a measure of what the banks must charge for money and that's how the rest of the world uses the LIBOR rate.

But as we've hinted, there's a far darker side and, as usual, we'll tell you about it even though other insiders won't.

Interest rates are not really a cost of borrowing – even though that's how they are portrayed to the public. To insiders, interest rates are a measure of risk. So even though banks and financial institutions use the daily LIBOR rate to "price" billions of dollars worth of financial instruments, what these institutions are really doing when they post their LIBOR rates is to look at each other's credit quality and assign a risk premium.

Thus, if LIBOR rates are rising, one way to interpret that fact is to conclude that the risk of doing business with other financial institutions is going up to. That creates an incentive for banks to "fib" when they submit information on the rates at which deposits were being offered.

This is true even when the financial markets are healthy and in good shape. But it's even truer when – as now – the markets are rattled and facing severe inflationary pressures.

Story continues below…

Here's why: The higher the LIBOR rate goes, the greater the risk of perceived default and the poorer the credit quality associated with the 16 banking heavyweights that submit the rates used to calculate LIBOR. What's more, those negative perceptions work their way through the balance of the world's financial system as a giant cascade of interlinked financial instruments.

If this doesn't make sense, think of it this way: What happens with LIBOR is not any different from what happens with rates assigned to home mortgages and credit cards – just on a far larger scale. If you're a good credit risk, you get low rates. If you're a bad credit risk, or are a high-risk borrower, you must pay higher interest rates because banks and other potential creditors view you as more likely to default on your obligations.

The bottom line is that LIBOR can actually be viewed as a kind of leading indicator.

In fact, I suggested as much back on May 8, when I correctly warned readers that the dollar rally under way at the time was nothing more than a "head fake of legendary proportions." At that point, the consensus view was that the dollar was finally emerging from a decline that had taken it down to record lows against key world currencies.

But when I noted that LIBOR was rising in concert with the dollar's embryonic rebound, it was clear to me that something was rotten in Denmark – or, in this case, London. Given that realization, I was able to conclude that the dollar's strength was nothing more than a temporary aberration and that the greenback would resume its decline once the inevitable new round of problems emanated from the financial-services sector.

And that's exactly what happened.

Since Money Morning published my "head fake" prediction, the "dollar rally" sputtered and died and the greenback resumed its downward spiral. And the catalyst for that dour turnabout was just what I'd predicted – a whole new round of financial write-downs and headlines about banks and investment banks facing major problems. Indeed, just this week there's been bad news surrounding Lehman Brothers Holdings Inc. (LEH), which wrote down another $3.7 billion in mortgage-backed assets.

So what's LIBOR telling us now?

That's simple. First, it's telling us that this mess is far from over. And second (and potentially even worse), it's making it very clear that inflationary worries are escalating.

It's also clear to me that the distrust between banks is growing. The three-month LIBOR rate recently jumped 10 basis points to reach 2.79%, representing the biggest LIBOR increase since August and the highest LIBOR level since April 30.

Which is why it would seem that there are more financial shenanigans to come. Indeed, I feel a bit like the announcer on the old BatmanTV series, asking in my best, scene-setting baritone voice:

"Could it be that we'll see another round of financial house cleaning in the next 90 days? Or are there additional credit-induced write-downs and earnings disappointments headed our way? To find out… tune in next week at the same Bat Time, and the same Bat Channel…"

LIBOR seems to be telling us that there's enough drama for several more episodes.

[Editor's note: Since this article was prepared, word has escaped from London that the biggest banks in England may be preparing to swap nearly £90 billion pounds sterling worth of mortgage-backed assets for U.S Treasury Bills with the Bank England. And, judging from how globally linked banks are these days, where there's smoke, odds are good that there's fire, too. That means we could see everything from higher interest rates globally to increasing defaults and heightened personal consumer financial trauma. Although that will create fear in the market place, it's important to note that with fear, comes opportunity.]

Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs High Velocity Profits, which aims to get in, target gains, and get out clean, and he's also the founding editor of Straight Line Profits, a service devoted to revealing the "dark side" of Wall Street... In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.

[…] words, the fact that Libor-Treasury spreads are wider today than they were a year ago suggests that the banks really don’t know who continues to hold the toxic debt instruments the entire world has … – despite a recent earnings parade of CEOs making claims to the […]

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